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The prices of corn and soybean meal have rocketed since late last year and are expected to remain high for much of next year because of continuing low crop yields. At the same time, chicken prices are near all-time lows on weak demand from the crucial restaurant and food-service industry, which represents two-thirds of the industry's sales, as penny-pinching consumers pull back on dining out.

Worse, there's a glut of chicken on the market as the industry heads into the fall, typically a slack season for the industry as folks put away their grills for the winter. Chicken producers, pumped up by record profits in 2010 and a highly profitable 2009, boosted production levels last fall and have only started to cut back. Result: Inventory in cold storage in June was up 100 million pounds from a year earlier, or 13%.

Chicken prices look likely to stay cooped up for a while.
JW/GettyImages

It's a perfect storm roiling the industry, and it's likely to continue into 2012. Already, three small, closely held chicken processors have declared bankruptcy this year. And there is real concern that deeper production cuts will be necessary to stem the losses.

"Conditions are very difficult," says Mike Cockrell, Sanderson's soft-spoken and straightforward chief financial officer. "The big question is, come the fall, if chicken will meet with even worse demand dynamics."

He doubts the 5% to 6% production cuts targeted by the industry will be enough to return it to profitability, especially in light of the recent market volatility and the low level of consumer confidence. "I'm a little bit skeptical," says Cockrell. "I wouldn't be surprised to see deeper cuts this fourth quarter."

In Cockrell's view, the current circumstances increasingly resemble those of 2008, which was the most severe downturn the industry has ever faced as corn soared and the global financial crisis hit, clobbering consumer confidence. Pilgrim's Pride, at the time the largest chicken company in the U.S., filed for bankruptcy protection that year. A year later the Brazilian giant and world's biggest beef exporter, JBS, bought Pilgrim's out of bankruptcy, paying $2.8 billion for a 64% share.

Sanderson, considered the Cadillac of the industry for its pristine balance sheet and efficient low-cost production methods, should be able to weather the storm, industry observers say. But at recent levels, the stock is vulnerable to further price declines. Morgan Stanley's Vincent Andrews expects the stock to drop by nearly 25% within the next 12 months, from $42 a share to $33, based on the industry's troubles.

USING A PROPRIETARY chicken-pricing model that he and his colleagues introduced in July, Andrews estimates Sanderson's production would have to decline by 9% for margins to return to more normalized levels, given its levels of feed costs. For margins to return to 2010 levels, Morgan Stanley reckons chicken prices need to average 79 cents a pound in 2012, 18 cents higher than now.

In May, after releasing its fiscal second-quarter results, Sanderson Farms indicated prices would need to increase by 15 cents across all chicken parts to bring 2012 margins back in line with those of 2010. Since then, however, prices have fallen still further. As of the second quarter, boneless, skinless breast meat averaged $1.34 a pound versus $1.61 a year earlier, and chicken wings averaged 77 cents a pound versus $1.23 a year earlier.

Sanderson is expected to show a loss of 68 cents a share when it reports fiscal third-quarter earnings on Aug. 25. That compares with a healthy profit of $1.55 a share in the year-ago period. For the fiscal year ending October, Wall Street is expecting a loss of $2.32 a share. Consensus estimates of $2.66 a share for fiscal 2012 could prove overly optimistic.

The Bottom Line

Pilgrim's Pride CEO Bill Lovette has called it an "unprecedented time" for the chicken industry. In reporting a 22% earnings drop for the second quarter, Tyson CEO Donnie Smith said, "The next few months will be very challenging." He forecast a likely loss in his chicken segment in the fourth quarter.

Conditions are so dire that the Agriculture Department agreed last week to help reduce the glut by buying an extra $40 million of chicken, in addition to the $100 million it typically spends each year to supply the national school-lunch program.

Investors looking for a meal ticket for their portfolios should look elsewhere.

Deep-Fried Losses

Sanderson Farms trades at a lofty level for a company headed for a loss this year.